On July 1, 2020, Justin Ltd., a dealer in machinery and equipment, leased equipment to Trudeau Inc. The lease is for ten years, and at the end of the lease period, title will pass to Trudeau. Justin requires ten equal annual payments of $ 62,100 on July 1 of each year, and Trudeau made the first payment on July 1, 2020. Justin had purchased the equipment for $ 390,000 on January 1, 2020, and established a selling price of $ 500,000 (which was fair value at July 1, 2020). Assume that, at July 1, 2020, the present value of the rent payments over the lease term discounted at 8% (the appropriate interest rate) was $ 450,000. The useful life of the equipment is 12 years. For the year ended December 31, 2020, and assuming that Trudeau uses straight-line depreciation, how much depreciation and interest expense should Trudeau record?

Question

Quizplus · Accepted Answer

Depreciation expense = (500,000 - 0) / 12 = $ 41,667
Interest expense = ($ 450,000 x 0.08) = $ 36,000
Interest expense for the year 2020 = ($ 450,000 - $ 62,100) x 0.08 = $ 31,656
Total interest expense over ten years = ($ 62,100 x 10) - $ 450,000 = $ 171,000
Total interest expense for each year = $ 171,000 / 10 = $ 17,100
Interest expense for the year 2020 = $ 17,100 + ($ 450,000 - $ 62,100 - $ 450,000 x 0.08) = $ 15,516
Therefore, depreciation for the year 2020 is $ 41,667 and interest expense for the year 2020 is $ 15,516, which are both given as option A.